Examining Bond Portfolio Trends: Third Quarter 2022
Examining Bond Portfolio Trends: Third Quarter 2022
Beginning in May 2012, we started tracking portfolio trends of our bond accounting customers here at SouthState|DuncanWilliams. At present, we account for over 130 client portfolios with a combined book value of $13.7 billion (not including SouthState Bank), or $105 million on average per portfolio. Twelve months earlier, the average portfolio size was $85 million which represents a 24% year-over-year increase. This percentage increase is trending down from recent quarters but is still healthy and speaks to the moderate loan demand and still sizeable but decreasing liquidity. Average portfolio size peaked at $110 million in May. As the economy weakens, as is anticipated given the Fed’s rate-hiking campaign, portfolio growth could very well accelerate in the latter part of 2022 and early part of 2023 as loan demand softens off the slowing economy.
The Fed’s hawkish tone that started last December has been reinforced through 2022 as the focus on inflation reduction is seen as Job 1 for the Fed. The expectation now is the Fed will hike two more times in 2022 and end the year at 4.00% – 4.25%. Another hike is expected in early 2023 to put the funds rate at 4.50% – 4.75%. While the Fed projects that will be the terminal rate in their latest forecast, the trend this year has been to bump forecasts higher, so reaching into the 5% range would not surprise us. Also, quantitative tightening is now at its peak monthly reduction of $90 billion per month, but It will still take several years to return to something close to the pre-pandemic balance sheet size. This quick pivot to aggressive tightening has led to record losses in bond prices this year, as you will see on the next page. As has been the case in 2022, in addition to dramatically lower prices in general, typical bank investments suffered another double-blow. First, spread widening on almost all non-Treasury investments combined with duration extension owing to the higher rate/slower prepayment scenario contributed further to lower prices.
After rising an astounding 161bps in the first quarter, 2yr yields added 58bps in the second quarter and another 132bps in the third quarter to end September at 4.28%. Meanwhile, 10-year yields rose 83bps during the first quarter, another 64bps in the second and 81bps in the third quarter to end at 3.83%. That price action kept the 2yr-10yr Treasury curve inverted throughout the third quarter while ending September at -38bps. The inversion is the deepest since April 2000 as short rates rose as the Fed revealed it will move the funds rate aggressively higher to combat inflation. Longer-term yields trended higher too but were a bit more range-bound believing the Fed would manage to quell the inflationary forces, but also slow the economy to recessionary territory. Now let’s turn our attention to the changes in portfolio allocation during the past year.
Changes in Portfolio Allocations
Let’s begin our portfolio review by revisiting allocations a year ago as shown in the pie chart to the immediate right. The MBS/CMO sector comprised 60.4% of portfolios, municipal allocations stood at 22.2%, Agency/Treasury investments were at 14.3% and the “Other” category (CDs, corporates and other floaters) was 3.1%.
Fast forward one year to September 30, 2022. The MBS/CMO sector comprised 54.8% of portfolios, a 5.6% decrease during the past year. This repeats the experience of the past two quarters that reversed a trend that had been in place for years of increasing MBS allocations.
The decrease in municipal investment that has been a feature this year slowed in the third quarter decreasing from 19.9% (13.9% tax-free, 6.0% taxable) last quarter to 19.5% (13.0% tax-free, 6.5% taxable). Prices held up early in 2022 but finally succumbed in March and April and the price declines continued in the third quarter. The higher yields and spreads are beginning to entice investors to allocate investment dollars once again into the sector as noted by the nearly static allocation from the second quarter, but the sector balance remains markedly down from its 2021 level.
The Agency/Treasury sector has been the one area that saw a definite increase during the year growing from 14.3% to 22.9% at quarter-end. Much of that increase has gone into Treasuries as investors took advantage of the much higher yields available in short to intermediate duration Treasury securities. The “Other” category decreased from 3.1% to 2.8% with corporate bonds constituting more than half the category at 2.3%.
Changes in Portfolio Performance
Now let’s look at portfolio performance trends. The graph below tracks average portfolio tax-equivalent book yield, duration, and unrealized gain/(loss) as a percent of book value. It also tracks 10-year Treasury yields and average portfolio size over the last two years.
As 2021 drew to a close, portfolio yields ended the year at 1.79%. The first quarter of 2022 saw the first signs of higher market rates as portfolio yields rose 5bps to 1.84%. In the second quarter, yields continued to improve rising another 12bps to 1.96%. As market yields continued to increase in the back half of the third quarter portfolio yields rose again, this time to 2.31%. That’s the highest portfolio yield since June 2020’s 2.39%. With a multitude of securities yielding 4% and higher, we expect portfolio yields to continue to lift in the months ahead.
As shown, 10-year Treasury yields (green line) finished 2021 at 1.51%. The fireworks, however, erupted in the first quarter as inflation fever and a newly hawkish Fed gripped markets. The 10yr yield finished the first quarter at 2.34%, an increase of 83bps and that continued into the second quarter with the 10yr yield ending June at 3.02%, an increase of 68bps. The third quarter followed the 2022 trend but with new intensity finishing up another 81bps to 3.83%. That’s the highest 10-year yield in our data stretching back ten years.
In the fourth quarter of last year durations were nearly unchanged from the prior quarter at 4.43 years as market yields remained range-bound and portfolio mix changed very little during that time. This rather docile behavior in duration changed dramatically in the first quarter of 2022 as the aforementioned increase in market yields took hold and durations extended to 5.00 years. That was the highest duration ever recorded in our data going back to 2012, until of course, the second quarter of 2022. As market yields continued higher, so too did durations, peaking at 5.57 years in April and finishing the quarter at 5.32 years. Despite higher yields in the third quarter, duration dipped to 5.16 years as changes in portfolio purchases during the quarter slightly shortened durations.
The increase in market rates combined with the extended portfolio duration had another detrimental impact to market values in all manner of fixed income securities. Unrealized losses started the quarter at –10.48% and ended the third quarter at a new all-time low for our records of –12.80% of book value.
Portfolio Purchases During the Third Quarter 2022
Finally, new investments in the third quarter of 2022 totaled $984 million, or $7.7 million for the average portfolio. These investments were led for the third quarter in a row by the Treasury/agency sector. That sector dethroned the MBS/CMO sector which had typically been the leading sector over the past several years. The Treasury/agency sector purchases comprised 55% of the $984 million in total purchases (41% Treasuries, 14% agency securities). The current Treasury/agency purchases at 55% easily exceeded the legacy total of 23%, so a definite shift in investments that began in the first quarter continued through the third quarter. The MBS/CMO sector followed with purchases equaling 30% (26% in MBS and 4% in CMOs). Compare these amounts to the fourth quarter of 2021 which comprised 45% of total purchases and you can see the shift from MBS/CMO to the Treasury/agency sector. The 30% MBS/CMO allocation compares to a legacy total of 55%. Of the MBS purchases, 29% were in 30yr pools, 25% in 20yr pools, 18% in 15yr pools and 9% in 10yr pools. The municipal sector followed at 13% of total purchases (9% tax-free, 4% taxable). The 13% muni purchases compare to 20% legacy muni allocations.
The average tax-equivalent book yield for third quarter purchases was 3.60% versus 2.94% in the prior quarter. The average effective duration was 3.14 years versus 4.03 years in the prior quarter. Negative convexity was –0.13 versus –0.25 in the prior quarter. Compare those figures to the legacy portfolio book yield of 2.31% and effective duration of 5.16 years. When they are purchasing bonds, portfolio managers are adding investments in 2022 that exceed their existing portfolio yields by a wide margin and with less duration than the legacy investments. With typical bank investments still on offer at yields 4%, or better, we expect continued improvement in portfolio yields with less duration risk during the current quarter.
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